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During
the frenetic months of the financial crisis, the Federal Reserve stretched
the limits of its legal authority by lending money to more than 100 banks
that subsequently failed.

The loans through the so-called discount window transformed a little-used
program for banks that run low on cash into a source of long-term financing
for troubled institutions, some of which borrowed regularly from the Fed for
more than a year.

The central bank took little risk in making the loans, protecting itself by demanding large amounts of collateral. But
propping up failing banks can increase the eventual cleanup costs for the
Federal Deposit Insurance Corporation because it keeps struggling banks
afloat, allowing them to get even deeper in debt. It also can clog the
arteries of the financial system, tying up money in banks that are no longer
making new loans.

The discount window is a basic feature of the central bank’s original
design, intended to mitigate bank runs and other cash squeezes. But access to
it historically has been limited to healthy banks with short-term problems.

Those limits moved from custom to law in 1991, when Congress formally
restricted the Fed’s ability to help failing banks. A Congressional
investigation found that more than 300 banks that
failed between 1985 and 1991 owed money to the Fed at the time of their
failure. Critics said the Fed’s lending had increased the cost of those
failures.

The central bank was chastened for a generation but in 2007, facing a new
banking crisis, the Fed once again started to broaden access to the discount
window. It reduced the cost of borrowing and started offering loans for
longer terms of up to 30 days.

More than one thousand banks have taken advantage. A review of federal data,
including records the Fed released last week, shows that at least 111 of
those banks subsequently failed. Eight owed the Fed money on the day they
failed, including Washington Mutual, the largest failed bank in American
history.

Charles Calomiris, a finance professor at Columbia
University who has studied discount window lending during previous crises,
said the Fed had not released enough information for the public to determine
whether some of the recipients were propped up inappropriately and should
have been allowed to fail more quickly.

Marvin Goodfriend, a professor of economics at
Carnegie Mellon University, said that such lending placed the Fed in the
inappropriate position of deciding the fate of individual banks, choices that
he said should be made by elected officials.

“What I think is the lesson from this is that the Congress needs to
clarify the boundaries of independent Fed credit policy,” Professor Goodfriend said. “There should be a mechanism so
that the Fed doesn’t have to make these decisions on behalf of
taxpayers.”

Boundaries are Not
the Problem

The Fed does not care about boundaries or what is legal or not. The obvious
implication is mechanisms to define Fed boundaries would be futile. We need
to eliminate the Fed itself.

Fed Uncertainty Principle Revisited

Inquiring minds and new readers are noting the Fed Uncertainty Principle, written April 3,
2008, predicted this event well before things got seriously out of hand.

Uncertainty
Principle Corollary Number Two: The government/quasi-government body
most responsible for creating this mess (the Fed), will attempt a big power
grab, purportedly to fix whatever problems it creates. The bigger the mess it
creates, the more power it will attempt to grab.
Over time this leads to dangerously concentrated power into the hands of
those who have already proven they do not know what they are doing.

Uncertainty Principle Corollary Number Four: The Fed simply does not
care whether its actions are illegal or not. The Fed is operating under the
principle that it's easier to get forgiveness than permission. And
forgiveness is just another means to the desired power grab it is seeking.

FDIC 's Role in the Mess

The
irony in blaming the Fed for increasing the mess for the FDIC, is that the
FDIC itself is fraudulent.

Notice
the misguided policies of the Fed and FDIC. By preventing all bank runs for
decades, the Fed instilled an artificial and undeserved confidence in banks.

It would be far better to disclose banks in trouble, let them go under one at
a time quickly, rather than have a gigantic systemic mess at one time.

Secrecy, in conjunction with fractional reserve lending is an exceptionally
toxic brew. Overnight trust can change on a dime, system-wide, and it did.

Moreover, by keeping poor banks alive (and my poster-boy for this is
Chicago-based Corus Bank for making massive amounts of construction loans to
build Florida condos), more money pours into failed institutions further
increasing toxic loans.

Failure of FDIC

FDIC is a part of the problem. When the government guarantees deposits,
everyone believes in every bank no matter how poorly they are run or what
risks those banks poses. No one has any incentive to seek a bank with good
lending practices. Instead they seek a bank that pays the highest yield
because it is guaranteed.

Driving deposits to banks that take the most risk is no way to run a system.
Yet, that is precisely what the FDIC does, up to the FDIC limit of course.

People look at FDIC as a big success because there was no crisis for decades.
Instead, we had one gigantic crisis culminate at once, hardly a fair tradeoff
for periods of artificially low problems.

FDIC is Fraudulent

No only is FDIC a problem, it is outright
fraudulent to guarantee deposits that cannot possibly be guaranteed in a
fractional reserve Ponzi-scheme system.

Mish

GlobalEconomicAnalysis.blogspot.com

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Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management. He writes a global economics blog which has commentary 5-7 times a week. He also writes for the Daily Reckoning, Whiskey & Gunpowder, and has over 80 magazine and book cover credits. Visit http://www.sitkapacific.com